Tales of a Technician: Theta and Covered Call Management | Tackle Trading
Just when I think I’ve exhausted my inventory of covered call insights I stumble upon yet another blog worthy concept. Today I’ll shine a light on how to identify the remaining profit in your trade, an essential skill for covered call management. For those otherwise unfamiliar with the covered call a quick review is in order.
The covered call consists of buying 100 shares of stock and selling a short-term call option. The short call produces monthly income with a dollop of downside protection. It also reduces your cost basis in the stock which boosts your probability of profit. Covered calls provide one of the simplest methods for sending the tricky little thief, Theta, to engage in a bit of thievery on your behalf. He’ll sneakily steal a bit of time value delivering it to your doorstep in increasing quantities day by day.
The more time value remaining in your short call the higher your remaining profit potential. The less time value remaining in your short call the less your remaining profit potential.
Before investigating further its worth pointing out the difference in calculating your remaining profit with an ITM covered call versus an OTM covered call. Let’s say XYZ is at $50 and you are short the April 55 call which is currently worth $1. Since the call is OTM its entire premium of $1 is time value. Your remaining profit, then, is the $1; that’s the amount Theta can steal for you.
Now, should the stock rise from $50 to $55 you can also make $5 on the stock so technically your max reward at this point is $6. Consider the OTM Covered call outlined on the left of the following graphic:
Now, suppose you instead sold an ITM covered call. With XYZ at $50 you short the April 45 call for $6. Since the call is ITM we have to strip out the intrinsic value to determine how much money Theta can steal — the extrinsic value, in other words. Since the 45 call is $5 ITM it has $5 of intrinsic value and $1 of extrinsic value. This means the potential profit due to time decay is $1, not $6. The max profit is also $1. By obligating yourself to sell the stock at $45 you are locking in a $5 loss in the stock. However, that $5 loss will be offset by the $5 of intrinsic value you captured in the call. See the ITM covered call outlined on the right side of the graphic.
Got it? Let’s move on. Here’s another way to visualize how much profit is remaining in a covered call. Simply head over to an option chain and view the extrinsic value column.
Like our previous example the stock price is around $50 and we’re looking at the ITM 45 call versus the OTM 55 call. The blue arrows and box identify the short 45 call has a mere 20 cents of extrinsic value remaining. That’s your remaining profit. On the other hand, the 55 call still has 71 cents of extrinsic value. While I probably would remain in the 55 covered call, I’d consider rolling the 45 covered call to the next month since it’s essentially maxed out its profit potential due to time decay.
I’m feeling generous this morning so allow me to include one more fascinating visual for covered call traders: the risk graph. When you model an option trade the risk graph always displays two lines. One reveals the trade today, the other reveals what the trade will look like at expiration. The difference between the lines is meant to illustrate the affect time decay will have on the trade. The distance between the two graphs reveals the remaining extrinsic value.
Take note of the following covered call risk graph. The green arrow illustrates how a covered call that sits ATM has a large amount of time value remaining. In contrast when your covered call moves deep ITM or far OTM it only possesses a small amount of extrinsic value regardless of how much time remains until expiration.
This is why it’s common practice to roll short calls when they’ve moved too far in- or out-of-the-money. There simply isn’t any more money for your pal Theta to steal.
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Originally published at https://tackletrading.com on March 7, 2016.
